Brexit Britain: Here's what the financial markets tell us about the economy effects of leaving the EU – Professor David McMillan
A year after Britain left the European Union, you could be forgiven for thinking the current economic gloom has nothing to do with Brexit, and everything to do with Covid.
But comparing the state of Britain’s financial markets with Europe and the US can give us a more accurate picture. That picture is complex, but unsettling.
Of the three broadly similar economic areas, UK GDP growth has been lower since 2016, fell further at the beginning of the pandemic, but rose faster in recovery.
Economic conditions remain mixed and depend on restrictions: UK retail sales fell in December as Omicron impacted, while overall GDP grew. However, although EU-UK trade in the year to October 2021 grew by two per cent, equivalent EU-US and EU-China figures are 18 and 17 per cent respectively.
We can also look at business investment in the UK – which plateaued in 2016 and remains around ten per cent lower than its pre-pandemic level – or the purchasing managers index (PMI), which is muted but positive, as indicators of whether firms expect the economy to grow.
Financial markets, however, provide the best place to consider our long-term prospects. Financial markets are forward-looking, revealing whether investors believe future performance will improve, and expressing confidence in an economy. Ultimately, where are investors prepared to put their money?
Stock prices rise and currencies become strong and stable with better times ahead, while the bond market provides cover for any increasing risk.
So, what do financial markets tell us?
Focus inevitably falls on a country’s main stock index. Over 2021, the US S&P500 increased by around 27 per cent (a similar value is recorded for the French CAC40); for the US Dow Jones and Euro Stoxx 50, growth was around 18 per cent.
The UK’s FTSE100’s figure was 14 per cent and it is the only market to remain below its pre-pandemic value. So, we see growth, as the economy recovers from the pandemic, but slower in the UK than other markets.
At the time of writing, an investment made at the beginning of 2020 would have returned 37 per cent in the US, 13 per cent in Europe, but minus 1.5 per cent in the UK.
The stock-price-to-earnings (p/e) ratio is an alternative judge of investor confidence. A high ratio indicates investors are willing to pay more for a stock now on the expectation of strong future performance.
The UK p/e ratio is lower than for the US, France, and Germany. This means that UK stocks are relatively under-valued, indicating doubts about expected growth of the UK economy.
This has prompted Goldman Sachs to suggest that investors buy cheap UK stocks, as they must inevitably catch-up. However, they made a similar statement at the end of 2020! International investors remain less convinced and are more likely to withdraw money from the UK, with £4.4 billion leaving UK equity funds in 2021, and £21bn since 2016.
Consideration of capital flows brings us to another key market: currency. While the stock market represents one indicator of confidence in expected economic performance (ie, of listed companies), the exchange rate reflects a wider measure.
Investors seeking UK assets, whether these are stocks, bonds, property, land, or companies to takeover, first need pounds. Capital flows reflect confidence among international investors in the whole economy, with vast sums of currency traded daily.
In its last survey, the Bank of International Settlements (BIS) noted that $6.6 trillion of currency are traded every day, including $844bn in pounds. How has the pound faired against the US dollar in comparison to the euro?
Over 2021, the pound fell by a small margin, around one per cent, while the euro fell against the dollar by seven per cent (with a corresponding rise of the pound against the euro). This seems good and indicates some confidence in the UK. But not from a longer perspective, with the pound eight per cent weaker and the euro essentially unmoved since 2016.
And the evidence points towards greater volatility in the pound over 2021. Statistical measures of fluctuations reveal that the volatility of the pound-dollar rate is over 20 per cent greater than the euro-dollar rate and with the coefficient of variation eight times larger. This heightened volatility indicates nervousness among investors, who are quick to withdraw money.
Greater volatility also comes with increased risk for investors, and costs for exporters and importers, with the shifts in the pound affecting the value of both portfolios and goods.
Do other markets indicate investor concerns about the longer-term performance of the UK economy? Here, we can look at the bond market for government debt.
Investors buy bonds because they provide a guaranteed return. Concerned investors buy bonds, confident investors sell them, as higher returns can be earned elsewhere. As an inverse relation exists between bond price and yield, confidence in the future performance of the UK would manifest itself in higher yields.
This is what we see in the short- to mid-term. But with lower long-term than mid-term yields, investors are buying insurance, which shows that doubts persist.
The UK remains an important financial centre. It is the largest market for currency trading, accounting for 43 per cent of trading based on the BIS survey cited above. The London stock market witnessed an increase in new stock market listing, with £13.7bn raised in the first three-quarters of 2021, notably in financial and technology firms. This is more than other European markets individually, although less in aggregate, with London no longer the largest European share trading market.
Through this mixed news, evidence from financial markets leads to two clear conclusions.
UK stocks are underperforming compared to main competitors, leading to them being cheap. And the currency market is experiencing greater volatility, which introduces additional risk and costs to the economy. Overall, our long-term future looks uncertain.
David McMillan is professor of finance at the University of Stirling Management School
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